TAILIEUCHUNG - Lecture Fundamentals of financial management: Chapter 16 - Gregory A. Kuhlemeyer, Carroll College, Waukesha

In this chapter we explore the principles of both operating leverage and financial leverage. The former is due to fixed operating costs associated with the production of goods or services, whereas the latter is due to the existence of fixed financing costs – in particular, interest on debt. Both types of leverage affect the level and variability of the firm’s after-tax earnings, and hence the firm’s overall risk and return. | Chapter 16 Operating and Financial Leverage © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, . Carroll College, Waukesha, WI Operating and Financial Leverage Operating Leverage Financial Leverage Total Leverage Cash-Flow Ability to Service Debt Other Methods of Analysis Combination of Methods Operating Leverage One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss). Operating Leverage -- The use of fixed operating costs by the firm. Impact of Operating Leverage on Profits Firm F Firm V Firm 2F Sales $10 $11 $ Operating Costs Fixed 7 2 14 Variable 2 7 3 Operating Profit $ 1 $ 2 $ FC/total costs .78 .22 .82 FC/sales .70 .18 .72 (in thousands) Impact of Operating Leverage on Profits Now, subject each firm to a 50% increase in sales for next year. Which firm do you think will be more “sensitive” to the change in sales (., show the largest percentage change in operating profit, EBIT)? [ ] Firm F; [ ] Firm V; [ ] Firm 2F. Impact of Operating Leverage on Profits Firm F Firm V Firm 2F Sales $15 $ $ Operating Costs Fixed 7 2 14 Variable 3 Operating Profit $ 5 $ 4 $ Percentage Change in EBIT* 400% 100% 330% (in thousands) * (EBITt - EBIT t-1) / EBIT t-1 Impact of Operating Leverage on Profits Firm F is the most “sensitive” firm -- for it, a 50% increase in sales leads to a 400% increase in EBIT. Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage. Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage. Break-Even Analysis When studying operating leverage, “profits” refers to operating profits before taxes (., EBIT) and excludes debt interest and dividend

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